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SCHOOL SPECIALTY, INC.
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SCHOOL SPECIALTY : Management's Discussion and Analysis of Financial Condition and Results of Operation (form 10-Q)

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11/08/2018 | 05:19pm EST

Quarterly Overview

School Specialty is a leading provider of innovative solutions that support integrated learning environments. School Specialty designs, develops and delivers a broad assortment of innovative and proprietary products, programs and services to the education marketplace, including essential classroom supplies, furniture, educational technology, supplemental learning resources ("Instruction & Intervention"), science curriculum solutions, and evidence-based safety and security training. The Company applies its unmatched team of subject-matter experts and customized planning, development and project management tools to deliver this comprehensive offering as the 21st Century Safe School™, a concept built around best-practice school environments that support the social, emotional, mental, and physical safety of students - improving both learning outcomes and school district performance. The Company provides educators with innovative and proprietary products and services, from basic school supplies to 21st century learning environments to Science, English and Language Arts ("ELA"), and Math core and supplemental instructional materials. Through its nationwide distribution network, School Specialty also provides its customers with access to a broad spectrum of trusted, third-party brands across its business segments. This assortment strategy enables the Company to offer a broad range of products primarily serving the preK-12 education market at the state, district and school levels. The Company is expanding the distribution of its products beyond selling directly to the education market into channels such as partnerships with e-tailers and healthcare facilities.

Our goal is to grow profitably as a leading provider of innovative 21st century classroom solutions including, supplies, furniture products, services and curriculum for the education market and select other markets. We have experienced three consecutive years of overall revenue growth. We expect to continue to achieve this goal over the long-term through an organic growth strategy based on leveraging our strong brand names, and long-standing customer relationships and distribution capabilities and transforming the Company's sales and marketing to a team-based selling approach focused on new customer acquisition, customer retention and penetration, and expanding into new markets or product areas. New revenue streams may include opportunities in areas that could expand our addressable market, such as distribution to non-education customers, expansion into new product lines, continued growth in our e-tail partnerships, and potentially, abroad in select international markets. In addition, the Company is committed to continuing to invest in product development in order to expand and improve its product offerings.

While remaining focused on lowering costs through consolidation and process improvement, the Company is equally focused on revenue growth and gross margin management. The Company believes the following initiatives will contribute to continued revenue growth, while effectively managing gross margin and operating costs:



  •   Successful execution of a new team sell model;




  •   Establish momentum in delivering the "21st Century Safe School™" value
      proposition;




  •   Improve the effectiveness of pricing strategies and margin management;




  •   Development of effective strategies to manage margin in competitive bidding
      scenarios;




  •   Increase product line specific sales and support expertise; and




  •   Execute on key platform investments to both drive efficiency and improve
      customer experiences.

Our business and working capital needs are highly seasonal, as schools and teachers look to receive a material portion of the products they purchase in the weeks leading up to the start of the school year. As such, our peak sales levels occur from June through September. We expect to ship approximately 50% of our revenue and earn more than 100% of our annual net income from June through September of our fiscal year and operate at a net loss from October through May. In anticipation of the peak shipping season, our inventory levels increase during the months of April through June. Our working capital historically peaks in August or September mainly due to the higher levels of accounts receivable related to our peak revenue months. Historically, accounts receivable collections are most significant in the months of September through December as over 100% of our annual operating cash flow is generated in those months.

The Company's fiscal 2018 third quarter results have been negatively impacted by staffing challenges in its fulfillment centers which the Company believes is related to historically low unemployment levels. We rely on seasonal employees, particularly in the months of June, July, and August, to meet the staffing needs within our fulfillment centers. In recent months, we experienced an exceptionally high level of turnover among seasonal




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employees, including those hired through third party staffing agencies. These staffing challenges have resulted in shipment delays. The impact to the third quarter financial results include lower revenues and higher fulfillment center and transportation costs. The negative impact to revenue in the third quarter was primarily timing as a high volume of orders carried over into October for fulfillment. This also had an impact on the timing of the Company's cash conversion cycle resulting in higher debt balances at the end of the third quarter of fiscal 2018. The Distribution segment's open order position entering the fourth quarter of 2018 was up year-over-year by $14.8 million. By the end of October 2018, the Company had shipped substantially all of the September month-end open orders and was current with deliveries. The shipping delays primarily impacted the Supplies product category, but also impacted the Instruction & Intervention and AV Tech product categories. This cash flow impact, however, is timing-related only. The Furniture and Agendas product categories were generally not impacted by the shipping delays as the majority of the products in those categories are not shipped from the Company's primary fulfillment centers. The Company did not incur a materially higher level of order cancellations due to shipping delays. As indicated, the Company's fulfillment center costs have increased as higher hourly wage rates and other monetary incentives were paid in order to attract and retain associates. In addition, higher turnover resulted in increased employee training costs and lower productivity.

Our ABL Facility and New Term Loan require us to maintain specified financial ratios. Following the end of the third quarter of fiscal 2018, the Company determined that the adoption of ASC 606 for purposes of calculating its fixed cost coverage ratio under the New Term Loan was required to maintain compliance with such ratio in the third quarter of fiscal 2018. On November 7, 2018, the Company entered into the Fifth Amendment of the ABL Agreement and the Second Amendment of the New Term Loan Agreement effective as of September 29, 2018 to, among other things, give effect to ASC 606 for the purpose of the computation of any financial covenant retroactive to December 31, 2017 as further discussed under "Note 17-Subsequent Events." As of September 29, 2018, the Company is in compliance with its financial covenants under the ABL Agreement and New Term Loan Agreement, as amended, and believes it will maintain compliance with these covenants over the next twelve months.

On August 18, 2017, the Company acquired of the assets of Triumph Learning. Triumph Learning is a publisher of state-specific assessment preparation, and supplemental and intervention curriculum products for the K-12 education market. For over 25 years, Triumph Learning's flagship product, Coach, has been utilized throughout education, providing educational facilities and teachers with hands-on assessment preparation books for ELA, Math, Science and Social Studies, with materials customized to state-specific best practices, along with a comprehensive series of supplemental and intervention resources for Math, ELA and Science. Solutions are delivered through multiple platforms, including both print and digital, as well as through third-party platforms and applications.

Triumph Learning's products are complementary to School Specialty's current offering and others that it intends to bring to market, as it expands its product offering in the Instruction & Intervention category. There are also significant potential synergies beyond the product offering as the Company anticipates the acquisition will result in a broader and more effective selling organization and an extended customer reach that will enable the Company to deliver a true blended learning solution to its customers.




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Results of Operations

Costs of Revenues and Selling, General and Administrative Expenses

The following table illustrates the primary costs classified in Cost of Revenues and Selling, General and Administrative Expenses:




                                             Selling, General and Administrative
             Cost of Revenues                             Expenses

• Direct costs of merchandise sold, net • Compensation and benefit costs for

of vendor rebates other than vendor all selling (including commissions),

payments for or the reimbursement of marketing, customer care and

specific, incremental and identifiable fulfillment center operations (which

 costs, and net of early payment            include the pick, pack and shipping
 discounts.                                 functions), and other general
                                            administrative functions such as
                                            finance, human resources and
                                            information technology.

• Amortization of product development • Occupancy and operating costs for

 costs.                                     our fulfillment centers and office
                                            operations.

• Freight expenses associated with • Freight expenses associated with

moving merchandise from our vendors to moving our merchandise from our

fulfillment centers or from our vendors fulfillment centers to our customers.

 directly to our customers.

                                            • Catalog expenses, offset by vendor
                                            payments for or reimbursement of
                                            specific, incremental and
                                            identifiable costs.

                                            • Depreciation and intangible asset
                                            amortization expense, other than
                                            amortization of product development
                                            costs.

The classification of these expenses varies across the distribution industry. As a result, the Company's gross margin may not be comparable to other retailers or distributors.

Three Months Ended September 29, 2018 Compared to Three Months Ended September 30, 2017

Revenues

Revenue of $290.3 million for the three months ended September 29, 2018 increased by $1.6 million, or 0.6%, as compared to the three months ended September 30, 2017. The adoption of ASC 606 resulted in $3.8 million of lower revenues in the third quarter of fiscal 2018 as compared to the third quarter of 2017, primarily within the Company's Distribution segment.

Distribution segment revenues of $270.9 million for the three months ended September 29, 2018 increased by 2.3%, or $6.1 million, from the three months ended September 30, 2017. Revenues from the Triumph Learning products, acquired in the third quarter of fiscal 2017 and reported in our Instruction & Intervention product category, contributed $5.1 million of incremental revenues in the third quarter of fiscal 2018. This increase was partially offset by the adoption of ASC 606, which decreased Furniture revenue by $4.0 million in the quarter. Revenues from the Supplies product category, our largest category, decreased approximately $5.2 million, or 4.2% in the quarter. However, incoming orders in the quarter were up 3.5% compared to incoming orders in the third quarter of 2017. Shipping delays in our fulfillment centers due to staffing challenges resulted in a year-over-year increase in our open order position entering the fourth quarter of $14.8 million. The Supplies category represented $10.8 million of the increase in open orders. Third quarter revenues in our second largest category, Furniture, were up 12.2%, or $10.8 million, compared to last year's third quarter, despite a $4.0 million negative impact of ASC 606 on the Furniture category in the quarter. Incoming Furniture orders remained strong throughout the quarter, up 13.7% compared to last year's third quarter. Adjusting the Instruction & Intervention category to exclude the incremental revenue associated with the Triumph Learning products, the category was down $0.6 million to prior year. Agendas revenues were $23.9 million in the third quarter of fiscal 2018, or down $2.7 million from last year's third quarter. AV Tech revenues of $3.7 million were down $0.6 million as compared to last year's third quarter. While we anticipated declines, the revenue performance of Agendas and AV Tech were modestly below our expectations.

Curriculum segment revenues of $19.3 million for the three months ended September 29, 2018 decreased by 19.0%, or $4.5 million, from the three months ended September 30, 2017. The decline was primarily related to a decrease in overall market opportunities for science curriculum in 2018 versus 2017. The third quarter of fiscal 2017 also included a particularly large school district order, totaling $3.0 million. With limited state science adoption related opportunities in 2018 and certain large opportunities expected to move from 2018 to 2019, we expected declines in segment revenues in fiscal 2018. Based on the current pipeline of significant state adoption and open territory related opportunities, we anticipate the Curriculum segment will experience significant growth in 2019.




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Gross Profit

Gross profit for the three months ended September 29, 2018 was $97.5 million, as compared to $107.1 million for the three months ended September 30, 2017. Gross margin for the three months ended September 29, 2018 was 33.6%, as compared to 37.1% for the three months ended September 30, 2017.

Distribution segment gross margin was 31.9% for the three months ended September 29, 2018, as compared to 35.3% for the three months ended September 30, 2017. Rate variances at a product line level negatively impacted gross margins by 330 basis points in the current year third quarter. The largest contributor to lower product line gross margins has been the mix of products sold within the respective product lines, particularly in the Supplies product line. In addition, lower margins experienced in certain state and large district-level pricing agreements has contributed to lower margins. In 2018, we also executed a strategic move to ensure we offered more competitive pricing on commodity items. While this had a modest negative impact on our gross margin in certain areas, these pricing actions have arrested revenue declines and contributed to growth in many product areas and improved overall customer penetration, as reflected in our year-over-year increases in orders. However, we have not been as successful as expected in the current year leveraging more competitive pricing in certain areas to drive growth in higher margin areas and within School Speciality's proprietary brands. Management believes driving sales growth in less-commoditized product areas and shifting mix to School Specialty's proprietary brands continue to represent an opportunity for profitable growth for the Company. Higher product development amortization in the current year third quarter resulted in 20 basis points of lower gross margin.

Curriculum segment gross margin was 57.2% for the three months ended September 29, 2018, as compared to 57.5% for the three months ended September 30, 2017. The gross margin decline was related to a specific larger order which, for strategic purposes, carried significantly lower gross margin than our typical gross margin. Although the transaction resulted in approximately 70 basis points of gross margin decline in the quarter, the Company does not expect future transactions to have gross margins significantly below the historical rates. This decline was partially offset with lower product costs in the current year third quarter.

Selling, General and Administrative Expenses

SG&A includes: selling expenses, the most significant of which are wages and commissions; operations expenses, which includes customer service, warehouse and out-bound freight costs; catalog costs; general administrative overhead, which includes information technology, accounting, legal and human resources; and, depreciation and intangible asset amortization expense.

SG&A decreased $5.1 million in the third quarter of fiscal 2018, from $64.7 million for the three months ended September 30, 2017 to $59.6 million for the three months ended September 29, 2018. The impact of ASC 606 on third quarter SG&A costs contributed $2.9 million of the decline. In addition, SG&A costs directly related to Triumph Learning, which was acquired during last year's third quarter, were up approximately $0.4 million in this year's third quarter. The Company did not incur transaction or integration-related expenses in the third quarter of fiscal 2018 as the integration was completed near the end of the first quarter of fiscal 2018, while last year's third quarter included $0.9 million of transaction and integration-related expenses.

Transportation costs increased by $0.9 million in the third quarter of fiscal 2018 due to a combination of incremental volume in the quarter and industry-wide increases in freight rates. Depreciation and amortization expense increased by $1.1 million in the current year third quarter related primarily to incremental depreciation associated with the Company's implementation of its new e-commerce platform.

These increases were partially offset by a combination of $1.8 million of lower catalog expense associated with changes in the number of catalogs produced and circulated and $2.6 million of lower performance-based incentive compensation expense in the quarter.

As a percent of revenue, SG&A decreased from 22.4% for the three months ended September 30, 2017 to 20.5% for the three months ended September 29, 2018.




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Facility exit costs and restructuring

For the three-month period ended September 29, 2018, the Company recorded $0.7 million of facility exit costs and restructuring charges. For the three-month period ended September 30, 2017, the Company recorded $0.1 million of facility exit costs and restructuring charges. The amounts in both periods were entirely related to severance.

Interest Expense

Interest expense increased from $3.5 million for the three months ended September 30, 2017 to $4.2 million for the three months ended September 29, 2018. Cash interest expense increased $0.6 million in the current year quarter due primarily to an increase in average borrowings of $17.8 million for the third quarter of fiscal 2018 versus the third quarter of fiscal 2017. The increase in average borrowings is related primarily to the acquisition of Triumph Learning in the third quarter of fiscal 2017, and the impact of shipping delays which has resulted in the Company's cash conversion cycle shifting to later in the year. In addition, the Company's borrowing rate in this year's third quarter was up approximately 60 basis points as compared to last year's third quarter due to a combination of increases to the LIBOR rate and higher applicable margins applied to LIBOR based on the Company's changes to the Company's fixed cost coverage and net senior leverage ratios in 2018.

Provision for (Benefit from) Income Taxes

The provision for income taxes was $14.5 million for the three months ended September 29, 2018, as compared to tax of $4.6 million for the three months ended September 30, 2017.

The effective income tax rate for the three months ended September 29, 2018 and the three months ended September 30, 2017 was 43.9% and 11.9%, respectively. The increase in both the provision for income taxes and the effective income tax rates is related primarily to the impact of permanent tax items, such as the Global Intangible Low-Taxed Income ("GILTI") provisions within the 2017 tax reform bill. Under SAB 118, the Company will record the one-time transition tax associated with the 2017 tax reform bill, in the fourth quarter of 2018, in the range of zero to $0.8 million. The amount will be finalized in the fourth quarter of fiscal 2018 as the Company completes its analysis of foreign tax credit utilization against this one-time transition tax.

Nine Months Ended September 29, 2018 Compared to Nine Months Ended September 30, 2017

Revenues

Revenue of $558.8 million for the nine months ended September 29, 2018 increased by $12.9 million, or 2.4%, as compared to the nine months ended September 30, 2017. The adoption of ASC 606 contributed $1.6 million of the incremental revenue, primarily within the Company's Distribution segment.

Distribution segment revenues of $521.3 million for the nine months ended September 29, 2018 increased by 4.7%, or $23.3 million, from the nine months ended September 30, 2017. Revenues from the Triumph Learning products, acquired in the third quarter of fiscal 2017 and which are reported in our Instruction & Intervention product category, contributed $16.2 million of incremental revenues in the first nine months fiscal 2018. After adjusting for the impact of revenues from our Triumph Learning products, Distribution segment revenues are up in the first nine months of 2018 by $7.1 million. Revenues in the first nine months of 2018 were negatively impacted by shipping delays experienced in our fulfillment centers. The Company entered the fourth quarter of fiscal 2018 with $14.8 million of incremental open orders, an increase of 51.5%, as compared to open orders entering last year's fourth quarter. Although revenues from the Supplies product category declined approximately $6.8 million during the nine months ended September 29, 2018, the open orders entering the third quarter in the Supplies category were up year-over-year by $10.8 million. Incoming Supplies orders continued to show momentum in the third quarter, up 2.9% year-over-year. Year-to-date revenues in Furniture were up 14.1%, or $21.8 million, compared to 2017. The adoption of ASC 606 drove $2.0 million of this increase year-over-year, although the full-year impact of the adoption of ASC 606 is expected to be minimal. The incoming order rate for Furniture products remains strong as year-to-date orders were up 13.4% through the end of the third quarter. Adjusting the Instruction & Intervention category to exclude the incremental revenue associated with the Triumph Learning products, the category was down 4.5%, or $1.2 million. However, order trends have continued to improve as the year progresses, especially in core proprietary products such as Wordly Wise and Spire, which are up nearly 4% year-to-date. In conjunction with the integration of the Triumph Learning sales force with our Instruction & Intervention sales specialists, we restructured our coverage model which has reduced the effectiveness of our market coverage in 2018. This integration is substantially completed and we expect to enter 2019 with a more effective sales team focused on the Instruction & Intervention category along with a stronger product portfolio. The Company's Agendas and AV Tech categories are




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down $4.8 million and $1.6 million, respectively, through the first nine months of fiscal 2018. While the AV Tech and Agenda categories were expected to decline year-over-year, both categories are performing modestly below expectations.

Curriculum segment revenues of $37.5 million for the nine months ended September 29, 2018 decreased by 21.7%, or $10.4 million, from the nine months ended September 30, 2017. The limited amount of state adoption activity in 2018 and fewer large opportunities in open territory states are the primary drivers of the year-over-year decline. However, the competitive positioning of the product line remains strong and the pipeline of opportunities for 2019 is significant and building. We currently expect significant revenue growth in the Curriculum segment in 2019.

Gross Profit

Gross profit for the nine months ended September 29, 2018 was $192.4 million, as compared to $202.1 million for the nine months ended September 30, 2017. Gross margin for the nine months ended September 29, 2018 was 34.4%, as compared to 37.0% for the six months ended September 30, 2017. Increased revenues contributed $2.0 million of additional gross profit offset by a combination of a shift in product mix, lower product level gross margins and higher product development amortization.

Distribution segment gross margin was 32.8% for the nine months ended September 29, 2018, as compared to 35.4% for the nine months ended September 30, 2017. A shift in mix at the product line level contributed approximately 40 basis points of gross margin in the first nine months of fiscal 2018. This positive impact has been driven by a relative increase in sales within the Instruction & Intervention product line, the impact of which has been partially offset by growth in the Furniture product line, which has gross margins that are below those reported for the Distribution segment. Year-over-year rate variances within product lines has had a negative impact on gross margin of 280 basis points. The components of the 280 basis point negative impact consisted of lower average selling prices, product costs, mix within the product lines, and freight rates for vendor direct shipments. Lower average selling prices and product cost increases both have had an 80 basis point negative impact on gross margin. The mix of products sold within product lines, most notably the Supplies and Furniture product lines, has had a 70 basis point negative impact on gross margins. Increases in freight rates for vendor direct shipments had a 50 basis point negative impact on gross margin. Higher product development amortization in the current year resulted in 20 basis points of lower gross margin. More aggressive pricing in certain large state, regional and district-level pricing agreements, which became effective at various points in 2017, contributed to the lower average selling prices noted above. In addition, the strategic move to more competitive pricing on commodity items also is a contributing factor in the decline. However, these pricing actions have driven growth and customer penetration in fiscal 2018. Year-over-year variances in gross margins have stabilized and the Company is focused on improving our mix of sales to include higher margin items and increasing penetration of School Specialty's proprietary brands. In addition, the Company believes it has an opportunity to better optimize performance within strategic purchasing cooperatives and large state and district-level pricing agreements. As public education's utilization of purchasing cooperatives increases the Company also believes that its long-standing presence within and unique ability to meet the needs of such cooperatives creates an opportunity for our organization.

Curriculum segment gross margin was 56.5% for the nine months ended September 29, 2018, as compared to 54.1% for the nine months ended September 30, 2017. Year-over-year reductions in product costs positively impacted gross margin by 200 basis points. Lower product development amortization in the current year contributed 40 basis points of the gross margin increase.

Selling, General and Administrative Expenses

SG&A increased $6.7 million in the first nine months of fiscal 2018, from $163.9 million for the nine months ended September 30, 2017 to $170.6 million for the nine months ended September 29, 2018. The increase in SG&A is primarily related to the Triumph Learning acquisition completed in August 2017, and incremental depreciation and amortization.

The Company's acquisition of Triumph Learning during last year's third quarter resulted in approximately $6.9 million of incremental SG&A costs in the first nine months of 2018 versus last year's first nine months. Approximately $1.5 million of the costs associated with Triumph Learning were related directly to the integration. As of the end of the first quarter of fiscal 2018, Triumph Learning was fully integrated into the operations of the Company. Depreciation and amortization expense increased by $4.2 million in the current year's first nine months related primarily to incremental depreciation associated with the Company's new phone system and new e-commerce platform implementations. The adoption of ASC 606 resulted in a $0.4 million decrease in catalog expenses in the first nine months of fiscal 2018 as compared to the first nine months of fiscal 2017. Under ASC 606, catalog costs are treated as a cost to acquire contracts and are not related to a specific contract, therefore are expensed when incurred. Prior to ASC 606, the Company capitalized catalog costs and amortized the costs over the revenue stream attributable to the catalogs. The Company expects to recognize lower catalog expenses during the fourth quarter of fiscal 2018 as compared to the fourth quarter of fiscal 2017, and full year catalog expenses for 2018 are anticipated to be lower as compared to 2017. Outbound transportation costs were up $3.7 million in the first nine months of fiscal 2018 related primarily to industry-wide freight rate increases.




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Remaining SG&A costs were down $3.9 million in the nine months ended September 29, 2018. The positive impact of lower incentive-based compensation expense and a decrease in catalog costs due to reductions in both the number of catalogs and circulation have been partially offset by increases in transportation expenses.

As a percent of revenue, SG&A increased from 30.0% for the nine months ended September 30, 2017 to 30.5% for the nine months ended September 29, 2018. Despite the year-to-date increase through September 29, 2018, the Company expects full-year 2018 SG&A as a percent of revenue to be down as compared to full-year 2017 SG&A due to the combination of operating leverage on anticipated revenue growth during 2018, and continued SG&A reductions tied to cost reduction and process improvement initiatives.

Facility exit costs and restructuring

For the nine month period ended September 29, 2018, the Company recorded $1.1 million of facility exit costs and restructuring charges. For the nine month period ended September 30, 2017, the Company recorded $0.4 million of facility exit costs and restructuring charges. The amounts in both periods were related entirely to severance.

Interest Expense

Interest expense decreased from $11.8 million for the nine months ended September 30, 2017 to $11.4 million for the nine months ended September 29, 2018. Non-cash interest and amortization of debt fees were down approximately $1.0 million year-over-year primarily due to $0.3 million of lower interest attributable to the Company's vendor note obligations recorded in 2018 as compared to 2017 and $0.3 million of lower amortization of debt issuance costs. Cash interest expense was up $0.6 million in the first nine months of 2018 as compared to the first six months of 2017. The incremental interest expense is related to increased average borrowings of approximately $12.9 million in the first nine months of fiscal 2018. The increase in average borrowings was related to the acquisition of Triumph Learning during the third quarter of fiscal 2017, and the impact of shipping delays which has resulted in the Company's cash conversion cycle shifting to later in the year.

Loss on Early Extinguishment of Debt

During the nine months ended September 30, 2017, the Company recorded a non-cash charge of $4.3 million related to the write-off of $3.1 million of remaining unamortized debt issuance costs and $1.2 million of remaining original issue discount both of which were associated with the term loan that was repaid on April 7, 2017. No such charge was recorded in fiscal 2018.

Provision for Income Taxes

The provision for income taxes was $9.4 million for the nine months ended September 29, 2018, as compared to $4.3 million for the nine months ended September 30, 2017. The current year provision is expected to be substantially offset by tax benefits recognized against the net losses expected to be generated over the remainder of fiscal 2018.

The effective income tax rate for the nine months ended September 29, 2018 and the nine months ended September 30, 2017 was 101.1% and 19.8%, respectively. The current year effective tax rate is significantly higher than the statutory tax rate as the impact of permanent tax adjustments, such as GILTI, and discrete items, such as realized built-in losses have a material impact on our full-year effective income tax rate due to the projected minimal amount of full-year pre-tax income. The Company expects fiscal 2018 cash taxes to be in the range of $1.5 to $2 million. Beginning in fiscal 2019, the Company expects its effective income tax rate to be more consistent with the statutory rate.

Liquidity and Capital Resources

At September 29, 2018, the Company had net working capital of $124.7 million, a decrease of $15.7 million as compared to September 30, 2017. Net working capital in the current year includes both $7.9 million of cash and $90.5 million of current maturities of long term debt. The Company estimates that the carrying values of its accounts receivable and accounts payable, as shown in the condensed consolidated balance sheets, approximate fair value. The Company's capitalization at September 29, 2018 was $331.6 million and consisted of total debt of $219.3 million and stockholders' equity of $105.5 million. The change in accounting principle (See Note 4) resulted in $0.1 million of decreased working capital.




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Net cash used by operating activities was $86.1 million and $44.7 million for the nine months ended September 29, 2018 and September 30, 2017, respectively. The increase in cash used by operating activities related primarily to decreased operating income of $17.2 million in the first nine months of 2018 versus the first nine months of fiscal 2017. The remainder of the increase in cash used by operating activities was related to incremental working capital changes in the current year. Delays in fulfilling orders contributed to the year-over-year increase in both accounts receivable and inventories.

Net cash used in investing activities was $12.4 million in the first nine months of fiscal 2018 as compared to $32.1 million in the first nine months of fiscal 2017. Last year's net cash used in investing activities included $18.1 million for the Triumph Learning acquisition. Excluding the net cash used to fund the acquisition, the Company expects net cash used in investing activities to increase by approximately $2.4 million for the full year fiscal 2018 as compared to full year fiscal 2017 due to investments in the Company's ecommerce platform, product information management systems and curriculum product development. The completion of these projects is expected to result in improvements to the Company's platforms and processes, lower both ongoing operating costs and future investments in systems, and enable revenue growth.

Net cash provided by financing activities was $74.8 million in fiscal 2018 versus $49.8 million in fiscal 2017. In both periods the net cash provided from financing activities represents net draws from the ABL Facility, which combined with beginning of period cash balances, were used to fund operating and investing cash outflows, as well as Term Loan repayments in fiscal 2017. Outstanding borrowings on the ABL Facility were $85.8 million as of September 29, 2018, while the excess availability on that date for the ABL Facility was $37.7 million. The Company repaid principal on its Term Loan in the amount of $10.2 million during the first nine months of fiscal 2018, which consisted of an excess cash flow payment of $7.8 million and regularly scheduled principal payments of $2.4 million.

The Company's ABL Facility and New Term Loan contain customary events of default and financial, affirmative negative covenants. Following the end of the third quarter of fiscal 2018, the Company determined that the adoption of ASC 606 for purposes of calculating its fixed cost coverage ratio under the New Term Loan was required to maintain compliance with such ratio in the third quarter of 2018. On November 7, 2018, each of which was effective as of September 29, 2018, the Company entered into the Fifth Amendment to the ABL Facility and the Second Term Loan Amendment. The Second Term Loan Amendment was entered into in order to (1) reduce its fixed charge coverage ratio for the five fiscal quarters ending December 29, 2018 through December 28, 2019, (2) reduce the number of days for fiscal 2018 during which the Company may have no revolving loans outstanding from 60 to 14 and adjust the time period of such reduction to be between December 15, 2018 and January 31, 2019, (3) to give effect to ASU 2014-09 for the purpose of the computation of any financial covenant retroactive to December 31, 2017 and for all other purposes effective as of the date of the Second Term Loan Amendment, (4) change the delayed draw term loan commitment termination date from April 7, 2019 to the effective date of the Second Term Loan Amendment and (5) provide that the Applicable Margin shall assume a net senior leverage ratio of greater than 3.75x from the date of the Second Term Loan Amendment until the Company delivers its financial statements for fiscal 2018 and the related compliance certificate.

The Fifth Amendment was entered into in order to: (1) give effect to ASU No. 2014-09 for the purpose of the computation of any financial covenant retroactive to December 31, 2017 and for all other purposes effective as of the date of the ABL Amendment, and (2) substitute the LIBOR Screen Rate (as defined in the ABL Amendment) with the LIBOR Successor Rate (as defined in the ABL Amendment) in the event that the LIBOR Screen Rate is not available or published on a current basis, it was announced that LIBOR or LIBOR Screen Rate will no longer be made available or a new benchmark interest rate has been adopted to replace LIBOR.

As of September 29, 2018, the Company is in compliance with its financial covenants under the ABL Agreement and New Term Loan Agreement, as amended, and believes it will maintain compliance with these covenants over the next twelve months.

We believe that our cash flow from operations, borrowings available from our ABL Facility and the remaining portion of the delayed draw term loan available under the New Term Loan will be sufficient to meet our liquidity requirements for operations, including anticipated capital expenditures, repayment of deferred payment obligations and our contractual obligations for the next twelve months.

Fluctuations in Quarterly Results of Operations

Our business is subject to seasonal influences. Our historical revenues and profitability have been dramatically higher in the periods from June through September, primarily due to increased shipments to customers coinciding with the start of each school year. Quarterly results also may be materially affected by variations in our costs for labor, the products sold, the mix of products sold and general economic conditions. Therefore, results for any quarter are not indicative of the results that we may achieve for any subsequent fiscal quarter or for a full fiscal year. In addition, the 2018 quarterly results may not be comparable to similar quarters in past or future years due to the fulfillment center staffing challenges in 2018. The staffing challenges resulted in orders being fulfilled in the fourth quarter of 2018 versus the third quarter.

Inflation

Inflation, particularly in wage rates, transportation costs, and energy costs has had and is expected to have an effect on our results of operations and our internal and external sources of liquidity.




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Forward-Looking Statements

Statements in this Quarterly Report on Form 10-Q that are not historical are "forward-looking" statements within the meaning of the Private Securities Litigation Reform Act of 1995. The forward-looking statements include: (1) statements made under Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, including, without limitation, statements with respect to our internal growth plans, projected revenues and revenue growth, margin improvement, capital expenditures, adequacy of capital resources and ability to comply with financial covenants; and (2) statements included or incorporated by reference in our future filings with the Securities and Exchange Commission. Forward-looking statements also include statements regarding the intent, belief or current expectation of School Specialty or its officers. Forward-looking statements include statements preceded by, followed by or that include forward-looking terminology such as "may," "should," "believes," "expects," "anticipates," "estimates," "continues," "projects" or similar expressions.

All forward-looking statements included in this Quarterly Report are based on information available to us as of the date hereof. We do not undertake to update any forward-looking statements that may be made by us or on our behalf, in this Quarterly Report on Form 10-Q or otherwise. Our actual results may differ materially from those contained in the forward-looking statements identified above. Factors which may cause such a difference to occur include, but are not limited to, the risk factors set forth in Item 1A, "Risk Factors" of our Annual Report on Form 10-K for the fiscal year ended December 30, 2017.

Other risks and uncertainties include, but are not limited to, the following: failure to comply with restrictive covenants under our credit facilities and other debt instruments; material adverse effects on our operating flexibility resulting from our debt levels; volatile or uncertain economic conditions; inability to timely respond to the needs of our clients; declining school budgets; cyberattack or improper disclosure or loss of sensitive or confidential company, employee or client data; and other factors that may be disclosed from time to time in our SEC filings or otherwise.




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